What are cyclical stocks? How to use them to your advantage?

Stock markets are one of the most volatile investment options for any investor. They have the potential for providing the highest returns as well as can potentially wipe out the entire capital investment of the investors. Therefore investments in stock markets are always said to be done with caution. There are a variety of investment options available for investors but the final investment decision is based on the performance of the stock. Certain stocks have a higher degree of dependence on the economy as a whole for their performance. These cyclical stocks are a good addition to the investment portfolio of investors. Given below are the meaning and other related details of cyclical stocks which can help investors make better investment decisions. 

What are cyclical stocks?

Stocks that are heavily influenced by the market conditions face extreme price volatility due to macroeconomic changes in the economy and are known as cyclical stocks. These stocks face tremendous growth in prices of their stocks in the event of a boom or an uptrend in the market. On the other hand, in the event of a recession or a downtown in the market, the share prices of these stocks face a significant loss of value. Some of the sectors that have cyclical stocks include the Automobile sector, airline sector, hospitality sector, manufacturing, etc. 

The investors’ behavior in terms of cyclical stocks reflects their expectations. When the market and the economy are in a boom, the per-capita income of investors is high which translates into higher purchases which imply higher revenue for the company and ultimately higher returns for the investors. Similarly, when the economy is facing a recession, investors tend to spend less on luxury goods like entertainment, automobiles, travel, etc. and the stocks of such companies lose their demand which affects their prices. The revenue of such companies also declines, further impacting their prices in the stock markets. This implies that the performance of the stock of the company and its business cycles is directly correlated to the performance of the cyclical stocks. 

Read more: Top stocks in airline sector, industry overview and future prospects

What are the pros and cons of cyclical stocks? 

Cyclical stocks have a huge investor base as it has the potential to provide huge returns to the investors. However, investment in such stocks should also be done after careful analysis to avoid any losses. Some of the key advantages and disadvantages of investing in cyclical stocks are mentioned below. 

Pros 

Some of the key advantages of investing in cyclical stocks are highlighted below.  

1. Huge growth opportunities 

Investment in cyclical stocks provides huge growth opportunities for the investors at the time of economic boom. These stocks tend to outperform the index in such scenarios and thereby have the potential to provide returns that are on average higher than what the market or the investors expect. 

2. Opportunity to make maximum capital gains 

Investors and traders with a keen eye to spot the most opportune time to enter into cyclical stocks investment have the opportunity to make maximum capital gains before they exit the market at the calculated levels. This helps in increasing the net portfolio returns of the investors at a faster pace.  

3. A true reflection of the economy 

the performance of the cyclical stocks is directly linked to the performance of the economy as a whole. Therefore, these stocks can be considered to be a benchmark for evaluating the economy and where it is headed. Analysts often reflect the status of the economy and the possible turn of the same based on the performance of the cyclical stocks. 

4. Easy identification of stocks 

These stocks are usually easily identifiable as they reflect the demand from the customers based on their purchasing capacities. In the event of a recession, the demand for goods and services belonging to cyclical sectors reduces and vice versa. 

Cons 

Some of the prime disadvantages of investing in cyclical stocks are

1. High volatility to market conditions 

These stocks are highly volatile stocks. Therefore, in case of a boom, they can outperform the benchmark, similarly, in times of recession they can fall way below the benchmark leading to extreme damage to the investment portfolio. 

2. Potential for severe losses 

Since the performance of these stocks is heavily dependent on the business and the economic cycles, there is a huge possibility of losses in the event of a recession. Investors can potentially lose their capital investment and therefore investing in these stocks should be after careful analysis of the stocks at both the micro and macro levels.

3. Careful analysis for entry and exit from cyclical stocks investment  

Investment in cyclical stocks is highly time-sensitive. Investors and traders need a careful analysis of stocks and the business cycles to understand the most profitable entry and exit points to increase the overall profitability of the investment portfolio. Any error in the same can lead to potential losses that can erode the returns from other investments. For this, investors and traders need a thorough understanding of market trends, market timing, and the ability to spot any reversals. 

Technical analysis is quite crucial in identifying the market trends for investing in cyclical stocks. This analysis helps the investors and traders identify the most opportune time for investment in cyclical stocks as well as pull out their investments at the onset of reversals. However, technical analysis can be quite difficult to understand especially for novice investors and traders. Therefore any errors in reading the technical analysis data and understanding the same can lead to huge losses. 

4. Not ideal for wealth creation and long-term investment 

Cyclical stocks make a good addition to the investment portfolio due to the possibility to gain higher returns. However, these stocks being highly volatile cannot be relied on for wealth creation. Especially, in the case of long-term investors with a lower risk profile and investors looking for more or less stable passive sources of income, cyclical stocks may not be ideal investment options. 

Read more : 5 commonly used indicators for technical analysis

What is the difference between cyclical stocks and defensive stocks?

Conclusion 

Cyclical stocks are stocks that have seasonal demands. Therefore, in times of peak demand, the returns from these stocks can be huge. It can help in boosting the net returns of the portfolio but can also drag them down severely in times of recession. Therefore, while adding these stocks to the portfolio is quite profitable, investors have to ensure that they are not dominant so as to protect the overall capital investments.

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